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Features : Banking In Brazil

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June 01, 2006

Global Finance discusses the Brazilian banking industry with some of the leading players in the business.

Jean Philippe Leroy is executive general manager at Banco Bradesco

GLOBAL FINANCE: What has been the recent performance of the Brazilian banking system and its leading players?
Jean Philippe Leroy:
It is performing well. For the past 12 years we have been in transition. We moved from a period of hyperinflation, where banks had a return on equity of around 10% to 15%. There were concerns in the market and among analysts about how sustainable this market would be once we did not have floating gains any more, but since the implementation of the “real plan” in the middle of 1994, the Brazilian banks have been very efficient. They moved comfortably from a market with very high inflation rates to low inflation rates. Profitability moved back in the second half of the 1990s closer to 20% and since 2000 has been moving higher than the 20% mark. On one hand we have better performance because banks are beginning to be more like banks—lending money to people, to companies. On the other hand, fees in general were rising and efficiency improving. Cost increases have been very close to inflation while gross revenues have been twice, three times or sometimes even more as a multiple of inflation. Bradesco has seen excellent opportunities for acquisitions. In the past 40 years it acquired more than 50 banks, but over the past eight years acquired more than 22 banks or asset management companies. We saw opportunities to move more into different sectors we thought would make strategic sense. Over the past three years, however, we have been reducing the number of acquisitions to concentrate our efforts on reducing costs. The profitability of the bank is now higher than the 30% mark, which has been adding a lot of value to our company. The stock performance has been very good, returning more than 120% last year.

GF:
The banking systems of Latin America’s two leading economies, Brazil and Mexico, are very different in terms of foreign ownership. How did this come about?
Leroy: Brazil is the only country in Latin America where the leading players are local. If we look at the 10 largest banks in Brazil in terms of assets, seven are Brazilian and three are foreign. Why is Brazil different? First of all because of its size. We have a country with a territory almost 90% the size of the United States, so the costs related to implement a retail bank in Brazil are high. It is thought that it costs roughly $1 billion to $2 billion to build every 1% market share. You must have at least 5% to be considered a national player so you need $10 billion of investment; there are few companies that commit to invest so much capital in a single country.

GF:
Brazil has a number of strong local financial institutions. How do they differentiate themselves to their corporate and individual customers?
Leroy: Banks in Brazil are not only very profitable; they are also very strong in terms of capital base. What differs would be their strategy. Sometimes one player is more focused on a specific region of Brazil; the other would be focused more on a specific type of product. Most of them concentrate their efforts in the large cities—São Paulo, Rio de Janeiro, Belo Horizonte, Brasilia and others. In our case the difference is that we are more a retail player. So the strategy differs between the companies. Normally, foreign players concentrate a lot of their efforts on working with companies, perhaps because they already have a very strong relationship. Also, they look after their relationships with the large European players because they already have a very strong relationship with them. Other players, maybe because of their capital base, concentrate more in different regions of Brazil. Bradesco, I would say, is a one-stop shop company. We try to be present everywhere. We try to be present for individuals and companies. The idea is to broaden the array of products and services to each and everyone, both in terms of banking and insurance.

GF:
Banks in Brazil are moving from being only providers of working capital to something broader, including providing help to companies in making sales and purchases. How is this happening, and how is it affecting Brazil’s companies?
Leroy: More and more banks are integrating their activities with their customers. The closer the relationship you have with your customer, the more you understand its needs, the better for the bank and the better for the customer. We aim to build a complete analysis of the needs of each and every customer, and we believe that with this approach we will be helping the companies—and helping us to achieve a higher share of wallet in the number of products and services we could be giving to those customers. We analyzed our whole client base and found we could be increasing the number of products per customer—and the profit per customer—by more than 40% after the implementation of our segmentation strategy. Before we did that, those customers had their needs fulfilled partially by Bradesco. Afterwards, Bradesco fulfilled their needs totally.

GF:
Brazil’s capital markets have been very active lately. IPO volume has been at 30-year highs. Why is this, and will it continue? Debt capital markets have also seen the introduction of novel products like perpetual bonds. Which investors do these products appeal to, and how do you expect these markets to develop in the future?
Leroy: Bradesco was the first company to issue perpetual bonds, so we opened the market for a lot of players to tap this product. Bradesco is a large player in capital markets and has now created a separate structure called BBI—Banco Bradesco Investment Bank—which will bring together all the different structures that focus on capital markets. In terms of the investors, on one hand you have institutional buyers, asset management companies, foundations and pension plan companies. Then you have the individuals: Today 30% of the volume on Bovespa, the São Paulo stock exchange, is traded by individuals. Also you have foreigners. This increasing interest is good for companies here because it forces them to focus on growing their earnings and dividends. With interest rates on a downward trend, you will have a higher chance of growth in debt.

GF:
What does Brazil have to do to maintain the strong interest from developed market investors?
Leroy: Brazil has to concentrate on maintaining and improving transparency, in terms of information, respect for contracts that already exist and the fundamentals of the economy. Companies are very well run. In terms of transparency, it couldn’t be better. We have more than 30 companies listed on the New York Stock Exchange, we have to follow the rules of Sarbanes-Oxley, and best practices of corporate governance in Brazil are very similar to those elsewhere.

GF:
An investment-grade rating seems to be in the cards for Brazil. What impact would that have on Brazil’s banks and capital markets?
Leroy: Investment grade is very important for the future of Brazil, but it’s only a means to an end. Most economists believe that Brazil will reach investment grade between the end of 2007 and the end of 2008. The risk of not achieving investment grade is almost zero. A lot of work has been done; a lot of improvement has been made. As a matter of example, a lot of things Mexico did to reach investment grade, Brazil already did. Once it happens, there will be a decrease in the cost of capital. More investors will be interested in Brazil; some say the level of investment will be at least multiplied by 10. That definitely is a plus.

GF:
What does the future hold for Brazilian banking and for Bradesco?
Leroy:
A lot of consolidation has already happened, but that will continue. The 10 largest banks hold today 70% of the assets, and we have 165 banks in Brazil. One study said that in Brazil there is room for 80 to 90 banks. Brazilian banks will continue to grow. The consolidation will continue, banks will become stronger and larger, increasing their reach. And Bradesco will be leading this movement, becoming not only stronger and larger but also better and better. In Banking and in Insurance.

René Böttcher is vice
president, depositary receipts,
Latin America, at The Bank of
New York

GLOBAL FINANCE:
Brazil’s capital markets have been extremely active lately. IPO volumes are at 30-year highs. Is this likely to continue?
René Böttcher: What is going on in Brazil right now is almost unprecedented in terms of numbers and the broad range of companies that are coming out and launching IPOs or follow-on offerings. This indeed provokes the question, Will that pace continue? It is difficult to imagine that we will see new companies entering the market at the same rate, but Brazil still has significant potential given the depth of its economy and wide range of industrial growth sectors. Notwithstanding major internal or external shocks, as they occurred in the past, we expect a steady flow of Brazilian equity transactions going forward, which are attractive to foreign and local investors.

GF:
What factors are contributing to the upsurge in IPOs?
Böttcher: There are a lot of elements that come into play. After the major Brazilian economic crisis and election doubts, which saw country risk and company valuations hitting record lows, there was huge investor uncertainty about the direction the country would take. From that moment on, however, Brazil witnessed a steady recovery of confidence driven by positive actions taken by the new government. The one topic in terms of capital markets that was key in this positive evolution was the improvement in local corporate governance standards. Brazil has made great strides in that direction. The creation of the Novo Mercado, largely expanding minority shareholder rights, gave investors abroad much more confidence in the market. Overall, the upsurge in IPOs to this level was mostly caused by a better equilibrium between supply and demand—on one side the supply being the companies and controlling shareholders that are more willing to offer their shares because of improved valuations. On the demand side you have a global liquidity surge looking to find a home for its money in search of improved returns. Brazil has become one of the major destinations of foreign investor money. If you look at the ADR segment, there are now almost 40 companies registered on the US exchanges that are fully US GAAP and Sarbanes-Oxley compliant and available to foreigners for investment. Additionally, there are a large number of Brazilian stocks available in DR form in the over-the-counter as well as the 144A/Reg S private placement segment.

GF:
How well has The Bank of New York’s Brazil ADR index performed in recent months? How was the evolution of trading volumes?
Böttcher: The evolution of the indexes is clearly reflected in the US dollar trading volumes, where Brazil’s global share has improved significantly over the past years. In April 2004 there was $5.5 billion in trading of ADRs on the US exchanges. In February of this year Brazil for the first time became the number-one ADR market in the world—ahead of long-time leader the UK. Also during the first quarter Petrobras became the first Brazilian company to take the global top spot in terms of US dollar ADR trading volumes. In other words, Brazil has been playing an important role in terms of equity returns. In 2005 the BoNY Brazil ADR index was one of the best-performing indexes, with a return of almost 55% in US dollar terms, making it one of the leading indexes in the world. This compares to a negative return of the Dow Jones industrial average during the same time period. Year-to-date the Brazil ADR index grew almost 30% in dollar terms, which makes it again one of the top-performing ADR indexes out there. So there is great momentum, but the remaining continuous risk for Brazil is its dependence on foreign investor money inflows.

GF:
What is driving foreign investor interest in Brazilian stocks?
Böttcher: One of the main drivers is investor confidence. Improved corporate governance will continue to play an important role. With the founding of IBGC, the Brazilian offspring of the Global Corporate Governance Network, this effort is now much more institutionalized in Brazil. Other important initiatives designed to boost investor confidence abroad include the BEST seminar series [Brazil Excellence in Securities Transactions]. BEST unites major stakeholders in the Brazilian capital markets such as the exchanges, settlement systems, regulators and the central bank, taking them on frequent road shows to the most important global financial centers. These seminars are aimed at institutional investors and other market participants, explaining to them the latest advances in the Brazilian capital markets from a structural point of view. That is a huge confidence enhancer. Also, large Brazilian companies are starting to converge their share classes, non-voting and voting, into one voting class, with some democratizing their share capital by creating a 100% free float. Last year a local company, Lojas Renner, was the first IPO in Brazil that had 100% of its share capital distributed. This year several large companies with ADR programs have announced transactions in this direction, raising the level of corporate governance and adding liquidity to their shares. Another important factor that drives foreign investor interest is a steady flow of new investment opportunities in new sectors and growth stories. Private equity funds that have seen their investments in Brazil mature have contributed largely to the recent wave of IPOs by bringing new companies to market through secondary and follow-on offerings.

GF:
What does Brazil have to do to maintain interest from foreign investors?
Böttcher: As I said earlier, corporate governance is key, but there are many companies that are still not there. So that will have to continue in the right direction. Of course, Brazil as an economy also needs to stay on the path of its reform program and maintain fiscal discipline in order to show ongoing progress. Within the group of BRIC countries [Brazil, Russia, India and China], Brazil still has the lowest level of economic growth. There is also an election coming up, which always catches the attention and imagination of investors.

GF:
Which investor segments should Brazilian issuers pay attention to?
Böttcher: In the past 24 months there have been huge shifts at the institutional and private investor level, in terms of the proportions of their portfolios invested in international equities. Institutional investors have aggressively increased the share of their portfolios in this segment of the equity asset class. On the retail side in the US there is strong and growing demand for investing in international stocks through ADRs. Investing abroad is not a novelty any more as people have easier access and are better informed about companies, including the ones in Brazil. In 2005, for the first time in 15 years, mutual funds that were investing internationally received more money inflows than domestically oriented ones. Brazilian companies should pay close attention to these trends in their IR efforts to broaden their shareholder bases.

GF:
The debt capital markets have also seen the introduction of novel products such as perpetual bonds coming from Brazil. Which investors do these products appeal to?
Böttcher: Brazilian companies have always been very innovative in coming up with new debt structures under often very difficult market conditions. In the past few years we have witnessed issuers consistently extending out the maturities of their bond offerings as economic conditions and country risk improved, issuing five-, 10-, 15- and even 30-year paper. Most recently we saw the emergence of perpetual bonds allowing companies to raise long-term funds at attractive rates. Interestingly enough, many of those bonds were bought by Asian investors. It remains to be seen, however, how long Brazilian companies will be able to raise money through perpetuals at attractive rates in a rising US interest rate environment as investors will start again demanding higher yields from emerging market issuers.

GF:
Analysts believe an investment-grade rating is in the cards for Brazil. When might this happen? What impact will it have on the capital markets?
Böttcher: Analysts have put different targets on it. Some say 2007; others 2008 or later. It is something that is clearly going to happen. In terms of how it will impact the capital markets, there are several interesting dynamics. On the one hand there are institutional investors that are prevented from investing in non-investment-grade stocks, so you could see a new group of investors entering the market. On the other hand, non-investment-grade stocks offer higher upside, so in turn it may not be as attractive to some aggressive growth investors any more as in the past. Overall, though, I think the impact will be positive for the Brazilian capital markets because it will further boost investor confidence. It will also allow companies to compete and raise money at more attractive rates, which in turn will support needed domestic investments, strengthening further the economy.

GF:
What impact has Sarbanes-Oxley [SOX] had on Brazilian companies wanting to list in the US?
Böttcher: Of course, as elsewhere in the world, Brazilian companies sat up and took note of Sarbanes-Oxley. Interestingly enough, not a single Brazilian company has yet decided to de-list because of this new legislation. In fact, since SOX was introduced, several companies have registered their ADRs in the US. Of course SOX is more costly, and its provisions are time consuming to implement. However, it is not such a huge issue for Brazilian companies because they are already complying with a lot of the provisions under Brazilian GAAP that are also required by SOX. The majority of IPOs in the Brazilian market today goes straight to the Novo Mercado, which demands the highest and most stringent level of corporate governance in Brazil. No doubt, Sarbanes-Oxley has slowed down the flow of potentially US-registered IPOs and equity offerings. However, many Brazilian companies that went public as a first step in Brazil will move on to register internationally as a next step as they grow in size. In the end, this is the only way to capture the widest foreign investor universe as possible and become truly global.

Silvio de Carvalho is executive
director of controllership at
Banco Itaú greenhouse gases

GLOBAL FINANCE:
How have the Brazilian banking system and its leading players performed recently?
Silvio De Carvalho: In the Brazilian financial sector, credit continues to grow. Credit to individuals increased 6.2% in the first quarter of 2006, following the trend verified in 2005 [growth of 29.7%]. Payroll advance loans, which have been the great driver of credit to individuals, seem to have stabilized, accounting for approximately 15% of the private sector loan portfolio in March. This reveals the strategy adopted by the main banks to benefit from the effects of the Brazilian economic growth: Focus on credit to high-yielding segments, such as individuals and small and medium-size companies. The large banks have been achieving record earnings: Itaú posted an ROE of 35.3% in 2005 and 36.3% in the first quarter of 2006.

GF:
Why are Brazil and Mexico’s banking systems so different in terms of foreign ownership? Will Brazil become more like Mexico?
De Carvalho:
Around three quarters of Mexico’s banking assets are controlled by foreign institutions. In Brazil that figure is around 22%. One reason for the difference is regulation: After entering NAFTA in 1993, Mexican authorities progressively approved the elimination of virtually every restriction to the presence of foreign banks. These global financial powerhouses put pressure on the Mexican banks, which suffered the effects of the rapid drop in interest rates and the need to gain scale in order to improve efficiency. In Brazil the legislation is not as liberal, so consolidation occurred with less participation from foreign banks. Also, the scale of the Brazilian banking system itself is an entrance barrier to foreign investors, largely due to the amount of investments that need to be made not only in the acquisition but also in technology, marketing and others. Many foreign banks entered the Brazilian market and left afterwards because of the difficulties in dealing with a huge retailing operation. Mexico also attracted more foreign investors because of its investment-grade status, unlike Brazil, which currently offers EMBI [emerging markets bond index] global yield spreads twice those of Mexico. Some other factors that make the Brazilian system unique are:

- all federal, state and local bills are paid in the banks, as well as public taxes, generating huge transaction volumes;
- high spreads, due to the tax burden, high administrative costs, loan losses and delinquency, plus elevated interest rates;
- high reserve requirements, reaching 45% of demand deposits;
- huge fixed costs;
- strong capitalization;
- satisfactory level of provisioning.

GF:
Brazil has a number of strong local financial institutions. How do they differentiate themselves to their corporate and individual customers?
De Carvalho:
On the individuals’ side, bank clients in Brazil tend to choose their bank of preference based not only on convenience, area of operation, products available and other commercial factors, but also on image, brand and tradition. This means the process of attraction and retention of customers is a long one, and local institutions with a tradition of soundness and profitability have a competitive advantage—provided they offer competitive services. It is worth mentioning that, according to the British consulting firm Interbrand, Itaú has the most valuable brand in Brazil, evaluated at $1.3 billion in 2005. Brazilian large retail banks have been heavily investing in opening new branches, acquiring smaller institutions, bank automation and aggressive use of marketing to attract and retain new customers. There still is a lot of room to grow, since only 30% of the Brazilian population has access to the formal financial system. On the corporate side, competition is much higher. The large companies work with virtually every representative bank in Brazil and have a lot of bargaining power, which explains the low spread charged in credit operations, for instance. Banks are now trying to differentiate themselves in investment banking, a segment that benefits from the economic stability, to offer corporate clients more profitable and sophisticated operations. Itaú, for instance, acquired former Banco BBA Creditanstalt, which merged with Itaucorp, our division dedicated to large companies, to form Banco Itaú BBA, a subsidiary of Banco Itaú Holding Financeira and the largest wholesale bank in Brazil. The key to differentiation also lies in segmentation. Through this process, banks can offer clients products and financial services tailor-made to their specific needs. Itaú has developed the structure, products and services to satisfy the needs of a wide variety of markets in Brazil and overseas. Through Banco Itaú, Banco Itaucred and Banco Itaú BBA, it is active in all areas of domestic economic activities.

GF:
Banks in Brazil are moving from being only providers of working capital to something broader, including providing help to companies in making sales and purchases. How is this happening, and how is it affecting Brazil’s companies?
De Carvalho: Brazilian companies are looking for sources of funding cheaper than credit. In this scenario banks need to focus on investment banking in order to create new structured operations in the local and foreign capital markets to meet these demands. Securitization and IPOs are really expanding products in the country, and banks are being demanded in these areas. This is the current scenario verified in the corporate segment. In the middle-market segment Itaú and the other banks are actively engaged in financing their acquisition of equipment and growing capacity.

GF:
Brazil’s capital markets have been very active lately. IPO volume has been at 30-year highs. Why is this, and will it continue? Debt capital markets have also seen the introduction of novel products such as perpetual bonds. Which investors do these products appeal to? How do you expect this market to develop in the future?
De Carvalho: We believe that the Brazilian capital markets will continue on the virtuous trend seen in the past couple of years. The macroeconomic scenario is positive, with stability of the currency and economic growth; public companies have been investing in transparency and corporate governance, thus lessening the investment risk; the individual investor, provoked by the high returns of the listed stocks and the popularization campaigns by Bovespa [Brazilian stock exchange], has returned to the market and is responsible for 30% of the volume of the stock exchange nowadays; the market authorities and the stock exchange are doing a good job in terms of regulations that provide safety and stability to investors who want to come to the Brazilian market; and, finally, the decrease in interest rates shifts investment from fixed income to variable income. In relation to perpetual bonds, some large and solid Brazilian companies have begun to issue these securities in the foreign markets. It is an option highly regarded by foreign investors looking for profitability with lower risks. However, we expect the full development of this market only after Brazil obtains its investment grade, when these bonds can pay lower remuneration rates.

GF:
What does Brazil have to do to maintain the strong interest from developed market investors?
De Carvalho: Brazil needs to position itself as a safe, reliable and profitable investment in the global emerging markets. The main condition for that would be the achievement of the investment-grade rating, but continuous efforts in transparency, corporate governance, advanced regulation and solid figures in the sovereign public accounts must be pursued.

GF:
Some analysts believe an investment-grade rating is in the cards for Brazil. When might this happen? What will be the impact on Brazil’s banks and capital markets?
De Carvalho: Itaú believes that the investment grade could come in 2008 if the macroeconomic fundamentals keep evolving at the same pace and no structural policies are substantially changed—i.e., target inflation system, fluctuation exchange, primary surplus, fiscal control, etc. It could come faster if the government invests in or stimulates the investment in infrastructure and performs microeconomic reforms—tax reform, mortgages reform, etc. The impact should be very positive for the capital markets, given the increase in the amount of capital that would be available for investment. This capital would come from new institutional investors that currently aren’t able to invest in Brazil because of its non-investment grade. And more importantly, these investments should be long term and structural, thus providing the country with the conditions to achieve sustainable development.

GF:
What does the future hold for Brazilian banking and finance? Will there be more consolidation? What will be the role of foreign banks? Will Brazil’s banks move to become more regional Latin American institutions?
De Carvalho: With the decline in the interest rate, a second consolidation movement is likely to occur, although it should be less intense than the first one, which took place in the mid-1990s. Brazil still has too many financial institutions operating in the country [around 150], which will need to gain scale to stay competitive in a lower-margin scenario. Maybe the consolidation could occur in specific segments linked to the banking sector. Foreign banks have come to Brazil, and some of them have left. The market continues to be dominated by the government-controlled banks, and five out of the six largest private banks have national control. For the moment there is no major opportunity of acquisition that foreign banks could enjoy to significantly change this scenario. Latin American markets are surely attractive for any major bank, given their growth potential. We believe Brazil still offers the best opportunities in the continent, and we are focused on growing within our boundaries. However, some opportunities can be enjoyed, and Itaú itself is currently holding an exclusive purchase option for Bank of America´s assets in Chile and Uruguay.